HUMAN AND FINANCIAL CAPITAL
Defining a Startup
– A startup is a business that is in the process of developing the underlying infrastructure needed to support future growth
– A startup is a business engaging in the the following three basic processes:
a. Developing and refining the offering and strategy to go to market
b. Obtaining initial funding to begin operations
c. Building a capable management team to handle operations
Startup Business Investment Stages
Relationship between Human & Financial Capital
*Human and financial capital resources can influence the business planning process and, in turn, be influenced by the business plan
*Human capital resources may include entrepreneurs, management team, strategic advisors and partners, and logistical advisors and partners
*Sources for financial capital include debt financing and equity financing
The Relationship between Human & Financial Capital
Elements of a Solid Business Planning Process
The major elements of a business planning process include the following:
– Defining the value proposition
– Framing the market opportunity
– Detailing how to reach customers
– Developing an implementation plan
– Evaluating potential external influences
– Articulating the revenue model
– Identifying needed people
– Calculating preliminary financial projections
– Establishing critical milestones
– Summarizing the advantage
Human Capital
*The role of human capital in a startup business is especially critical because, for a time, it is the only resource available.
*The human capital attracts the financial capital.
– When investors consider funding an earlystage company, they assess its human capital
– Who is the entrepreneur?
– Does she have the drive to see this business through?
– Who is on the management team?
– Will they be able to execute?
Characteristics of Successful Entrepreneurs
Key characteristics common to successful entrepreneurs include the following:
– Keenly Observant
– Willingness to take risks
– Drive
– Flexibility
– Vision
The Trials & Tribulations of the Entrepreneur
From the outset, the entrepreneur is faced with reconciling several difficult paradoxes:
– Being visionary vs. being realistic
– Generating quick returns vs. investing in the future
– Optimism vs. pragmatism
The Entrepreneur & The Idea
Some of the most common types of business ideas include the following:
– Introduce a new product (new software—MP3)
– Introduce a new service (overnight delivery—FedEx)
– Improve an existing model of business (selling books on the Internet—Amazon.com)
The Management Team
The core team consists of individuals essential to the early formative days of the startup who will fill the following three roles:
– Technology specialist
– Sales and marketing specialist
– Execution specialist
*Extended management team can be created on an as-needed basis, depending on how quickly the startup is growing.
– Chief operating officer
– Chief financial officer
– VP of marketing
– VP of sales
– VP of business development
– Chief people officer
Strategic Advisors & Partners
*Strategic advisors and partners provide the startup with strategic direction, advice, and in many instances credibility for the organization as a whole.
– Advisory board members
– The board of directors
– A strategic association
– A strategic alliance
Logistical Advisors & Partners
*Logistical advisors and partners differ from the strategic advisors and partners in that they are more involved in the day-to-day operations of the business.
– Necessary logistical advisors and partners include certified public accountants (CPA) and legal counsel
– Supporting logistical advisors and partners serve as outsourced, human-capital leverage for the startup and may include intermediaries, consultants, and incubators
Financial Capital
• Sources of debt financing (commercial banks, trade credit)
• Sources of equity financing (bootstrapping, venture-capital)
• Strategic investors are concerned how a certain business compliments their current activities
• Financial investors are concerned with return on investment (ROI), internal rate of return, cost of capital, and return on equity
Debt Financing
*Trade credit
– Is credit extended to a business by its suppliers.
– Suppliers typically offer trade credit to buyers with an established track record of making prompt payments
– Hidden interest rate cost
*Commercial bank loan is, typically, an installment loan in which the business borrows a certain amount of money for a specified period with either a fixed or variable interest rate
*Bank loans can be relatively difficult to obtain, especially for early-stage businesses with little collateral and no positive cash flow
Equity Financing: Bootstrapping
*Bootstrapping
– Is the art of using personal resources to finance the early stages of a startup
– It may include taking a personal loan, mortgaging a home, using credit cards or savings accounts
– It provides the most viable option for the entrepreneur when the startup is in the earliest stages of business, especially during the stages that involve proving the business concept
– It allows the entrepreneur to control the company and refine his business strategy without pressure from outside investors
– Disadvantage of bootstrapping: it is unlikely to provide sufficient cash for a good business concept to grow quickly beyond the earliest stages
Equity Financing: Venture Capital
*Venture-capital firms
– Are usually private partnerships or closely held corporations that raise money from a group of private investors
– Typically invests $250,000 to $10 million in a business in exchange for a 30 to 40 percent equity stake and a seat on the board of directors
*In addition to receiving cash, the entrepreneur receives guidance for building the startup
*Venture capitalists, typically, charge management fees on the order of 1 to 5 percent of the capital investment in a startup
– Seeks opportunities that will return 10 times the original investment within five years, but realizes that each investment is a gamble and that only 10 percent are likely to succeed
– The biggest disadvantage of venture capital funding is the source’s concern with the bottom line
Venture Capital Investments – Breakdown by Stage
Equity Financing: “Angels”
“Angels” are wealthy individuals who invest personal capital in startups in exchange for equity or sometimes a seat on the board of directors.
*Its critical for the entrepreneur to develop a network of individuals within the industry to gain introductions to potential financiers because “angels” seldom look at unsolicited business plans
*Business plans are evaluated based on the quality of the management team, market potential for the business idea, and the track record of the entrepreneur
*Typically, “angels” are more flexible in accepting changes in the original business plan if it is necessary
*“Angels” tend to be more involved in the day-to-day” operations of startups
Equity Financing: Corporate Ventures
*Large corporations sometimes set up venture funds as a subsidiary that can make investments on behalf of the parent company, referred to as either corporate venture or “direct investors”
*Corporate-venture funds– invest in complimentary business for primarily strategic reasons.
*In exchange for cash, capital ventures seek an equity stake in the company and access to the company’s technology or product
*Established corporations can offer the operational expertise as well as the credibility and visibility that come from associating with an established high-profile parent
The Business Plan
A business plan should provide the following information to a potential investor:
– Description of the product or service that will be offered and the value proposition for the customer
– Summary of the size and nature of the market opportunity
– Explanation of the revenue model
– Profiles of the management team, advisory board, and board of director members describing specific relevant skills and expertise
– Clear articulation of the startup’s core competencies and sustainable competitive
advantage
– Summary of financials and financing needs
Valuation
*Valuation– is the art/science of trying to determine the worth of a company.
Methods used in valuing a company:
1. The Comparables Method
– Determine the worth of a company by comparing it to other similar companies
• The companies should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure
– This method assumes that similar companies exist and that the information for comparison is available
2. The Financial Performance Method
– Uses a company’s earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows
The Discounted Cash Flow (DCF) is determined from:
– Proforma Income Statements
– Free Cash Flow
– Terminal Value
– The Venture Capital Method
*VC’s use a hybrid valuation method, looking at both comparables and free cash flows
*To compensate for their high risk investments, VC’s apply a very large discount rate to estimate the company’s present value
*To compensate for future dilution, VC’s require a higher percentage ownership (for a given investment) based on an estimated retention ratio
*This valuation method is necessarily subjective
Typical Discount Rates by Funding State
Negotiations
Principles for Entrepreneurs
*Investors want to know two things: What is the opportunity and why is this management team the best to pull it off
Guidelines for pitching an investment opportunity:
– Know the audience
– Keep the presentation concise
– Talk about the management team
*Term Sheet
– It is a non-binding description of the proposed deal between the financier and the
entrepreneur
– Itis analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU)Securities
Types of Securities:
*The type of securities chosen by the company and the investor reflect the risk/reward appetite
1. Zero Coupon Bonds – Upon maturity of this security, the investor redeems the initial investment and interest at a predetermined rate.
2. Convertible Debentures – These securities are loans that are ‘converted’ into common stock (equity).
3. Preferred Stock – This is the most commonly used security with VCs Rights & Priviledges of Investors
Common rights that investors demand are:
• Right of First Refusal
• Preemptive Right
• Redemption Rights
• Registration Rights
• Covenants
• Antidilution Provisions
Pre- & Post-Money Valuations Made Easy
Venture-Backed IPOs, 1995-2001
Exit
Initial Public Offering (IPO)
*Determining the Right Time for an IPO
– Asses if the company is ready for an IPO
– Asses if the market is ready to accept their offering
The IPO Process
– Selection of Underwriters (the underwriters are the bankers that will arrange for the purchase of stock for a commission)
– Preparation of Registration Statement for SEC (create prospectus outlining the company’s business and financial fundamentals)
– Distribution of Preliminary Prospectus – or ‘Red Herring’
– Preparation for and Completion of the Road Show (he company’s offering is presented
directly to potential investors)
– The Incorporation of SEC comments into the Registration Segment
– Agreement on a final share price and number of shares to be offered
– Close of the offering and distribution of the final prospectus
Mergers and Acquisitions (M&A)
*M&A can often achieve the same goals as IPO (e.g. liquidity and increased valuation) with lower potential risk
*In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares
*In an Acquisition, one company buys another, usually with cash and/or stock
*Analysts predict that M&A will become increasingly popular
IPO Pros & Cons
Internet Mergers & Acquisitions in 2001
E-COMMERCE 